Investing 101: How The Stock Market and Investing Works

What is the stock market? What is a stock? How do I learn how to invest? These and more are all common questions asked by new investors.

If you’ve decided to embark on the journey of the individual investor, you’ve come to the right place. Here are some stock market and investment questions, tips, and terms that will help you find success along the way:

Why do people invest?

As humans, our earnings potential is limited by time.

We can only work so many hours over a day, week, year, and lifetime. Investing allows people the opportunity to increase wealth or supplement income by purchasing investment “vehicles” (stocks, bonds, mutual funds, real estate) in the hope of its value appreciating.

This is a key element in preparing for retirement and becoming financially independent.

What is a stock?

A stock denotes partial ownership in a corporation. Firms can issue stock privately and publicly and stocks issued publicly trade across financial markets.

Two types of stock are preferred and common shares. Preferred shares usually carry more stockholder rights, like guaranteed dividend payments. Common shares are what investors typically trade.

Where do stocks trade?

There are two types of markets: primary and secondary.

Primary markets are where financial securities are created and then initially sold, usually to a limited investor group.

The capital raised from the initial public offering is then split between the investment bank who facilitated the IPO and the underlying firm.

Secondary markets are where the stock is traded between investors.

You can think of this like a farmers market, a place where people gather to buy and sell produce. The financial markets are where investors come to buy and sell shares. These markets operate at physical exchange locations and through extensive online networks.

Domestic secondary markets include the New York Stock Exchange (NYSE), NASDAQ, and AMEX. The London Stock Exchange and Hong Kong Stock Exchange are notable international secondary markets.

Knowing the difference between primary and secondary markets is important. (Photo Credit: Newscom)

Because of the large volume of trades taking place, these markets are considered to be highly liquid, reducing investor risk. The more liquid the market, the easier an investor can find a counterpart to trade with at a more efficient price.

Be wary of trading stocks on the over-the-counter bulletin board (OTCBB). Over the counter markets, also known as pink sheets, are where stock from firms who do not report (qualify) to the SEC are traded.

Why does the price of a stock change?

The catalysts that can influence a price of a stock are endless, but to understand how market forces shift prices we need to appreciate basic economics: supply and demand.

As more investors buy shares of a company (supply < demand), and the total “supply” of shares stays constant, the increased demand pushes the share price higher. Inversely, as more investors sell shares (supply > demand), the downward pressure lowers the stock price.

The possibilities of market influences are endless. Factors such as quarterly earnings, management performance, sector conditions, and insider information are all common influences of price adjustments.

Many academics and investors believe that all known information about the company is reflected in the share price, which is called the efficient market hypothesis.

What is intrinsic value?

Intrinsic value is the “true” value of the company, which may or may not be its current stock price.

Intrinsic Value is often called Fundamental Value. (Photo Credit: The New Yorker)

If an investor calculates an intrinsic value of a firm that is higher or lower than it’s market price, they can buy and sell shares based on this knowledge.

Of course, the intrinsic value calculation is by no means what the stock price will be, rather an educated guess of whether the company is overvalued or undervalued and by how much.

Common methods for finding intrinsic value are based on the companies’ dividends and cash flows metrics.

The total value of a firm’s equity is called market capitalization, or market cap. The number of shares outstanding multiplied by the stock price is the value of the underlying firms equity. Companies can be categorized by the relative sizes of their market caps, from nano-cap (below $50m) to mega-cap (over $200b).

How do I buy a stock?

Before technological advancements, physical exchanges and trading pits were the only way to buy and sell shares.

If an investor wanted to commit a trade they had to call their broker, who would then call the order in to a representative on the trading floor to be executed. As you can imagine, the time it took to complete a trade greatly varied.

Today, you can still physically trade shares at exchanges in the pits, but the volume of these trades (relative to electronic) is nowhere near what it used to be 30 years ago. Most of the exchanging of shares is now completed in a tenth of a second. Investors can watch market conditions and trade accordingly from almost anywhere in the world.

There are two types of brokerage: full service and discount.

An example of a full service is Edward Jones. These brokerages offer their clients personal investment advice and many other services to help them reach their financial goals, but this comes at a price. The financial advisor charges for specific actions and usually takes a percentage fee of the investor’s portfolio for managing their assets.

A discount brokerage is where an investor can open an account and execute trades for a relatively small fee per transaction (~ $10). Investors can open an account and trade on their own for a relatively small fee per transaction, but they do not receive much investment advice. Many brokerage firms offer the investor the option to choose between full-service and “discount” depending on their risk tolerance and goals.

Another way to buy shares is through dividend reinvestment plans. DRIPS allow investors to buy shares directly from the company, minimizing the costs of the transaction. Not all companies have DRIPS, which can limit this type of investor to the total possible firms to choose from.

What strategies are there to investing?

Strategies to investing are as unique as each personality.

Investment strategies are often the result of market experience, education, and financial influences. These strategies are often categorized by their analysis: fundamental, technical, or a blend of the two.

Fundamental analysis is the process of valuing a company based on their financial data and overall industry performance (economic factors). Fundamentalists believe that markets can falsely value a firm in the short run, but the long run price will reflect its intrinsic value. Fundamental investors use this knowledge in attempt to exploit short run price differences.

Technical analysis relies on charts and trends in the price of the stock (psychological factors). These investors do not care as much about the underlying stock value rather they try to exploit patterns caused by the emotions. They use factors like trade volume and historical price movements as a basis for predicting the future.

Keep Learning!

Now that you’ve taken the first step to learning how to invest, we urge you to keep reading and learning as much as you can. We’ll continue posting helpful information, examples, case studies, and more. And if you have a topic you’d like us to write about, fill out the form in the sidebar to the right and we’ll put it in the queue!

Also, create a free account on SprinkleBit and take advantage of our virtual stock market simulator. The best way to perfect your trading is by practicing, and our simulator is designed to give you real world trading experience before you try the real thing. Also, take time to go through our free, interactive investing and finance education.

At SprinkleBit, founded in 2011, we believe that if you have a dollar, then you have what it takes to be an investor. Sometimes you just need a little extra help to build your confidence. With our virtual simulator and our 24 free SprinkleBit University chapters, you will be able to learn the ins and outs of the market risk-free. Once you're ready to dive into the real thing, the community will be right there with you to help you on your journey. Dive in and start taking control of your financial future. You won't regret it. For more information and to become a member of the SprinkleBit community, click here.